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The Fed and the ECB are flexible in their plans to normalize monetary policy
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The markets' attention is now focused on key signs of a slowdown in the United States and China.
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Throughout the summer, the financial markets' attention has shifted from the sovereign debt crisis in the euro area towards the signs of a slowdown in the United States and China, to the extent that there are even fears of a recessionary and deflationary scenario in the US economy. Up to a point, analysts had already anticipated a slowdown in the pace of growth, both in the case of the United States, due to the disappearance of fiscal stimuli and other temporary factors, and in China given that, some months ago, the government adopted a series of measures to restrict the economy and bank credit in order to avoid unwarranted overheating. The surprise has been the simultaneous nature and intensity of the economic slowdown in both regions, shifting attention away from the gradual stabilization of the crisis in the euro area and Germany's satisfactory figures.
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Yields on bonds drop significantly, while equity's performance is lacklustre.
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Consequently, and within a scenario characterized by low volumes of trading typical of this time of year, the most outstanding movements have been seen in the money and bond markets: a notable drop in interest rates in most instruments, both by public and private issuers and for all maturities. The stock markets have seen irregular, lacklustre performance. In currency markets, the dollar has been weak but without any major tension.
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The central banks show flexibility in implementing their policies to underpin economic recovery.
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The main central banks have once again shown notable flexibility in the orientation and implementation of their policies, given the challenges appearing in the atypical post-crisis financial cycle we're currently immersed in. Consequently, while the Federal Reserve (Fed) helped out via additional measures of a quantitative nature, the European Central Bank put a stop to theirs.
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In fact, at its meeting held on 10 August, the Fed decided to delay the normalization of its monetary policy. Specifically, the central bank decided to reinvest the funds from maturities in its mortgage bond portfolio in buying up public debt. In practical terms, this is the equivalent of aiming to keep the level of its balance sheet around 2.3 trillion dollars, which is significantly different from its previous strategy of gradually reducing both assets and reserves, either automatically through maturities as well as through specific measures (reverse repos, term deposits, etc.). In this way, the Fed is hoping to avoid the risk of tightening up its monetary policy too quickly, given the still fragile economy which the organization itself has acknowledged, slightly downgrading its growth and inflation forecasts.
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Investors have accepted the central bank's view and futures markets have therefore decided that the Fed won't raise the reference rate until the end of the coming year and even then very gradually. This has caused the interbank dollar rate to relax significantly, down to levels close to the minimums at the beginning of the year.
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The ECB decides to keep its official interest rate at 1%.
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The actions taken by the European Central Bank (ECB) are in line with the tentative improvements in financing terms both for governments and banks, particularly in the periphery of the euro area. Consequently, at its meeting on 5 August, the ECB decided to keep the official interest rate at 1%. Jean-Claude Trichet, the ECB President, stated that the recovery was very likely to take root and the risk of recession in the euro area as a whole could be ruled out; however, he stressed that there's still a lot of uncertainty regarding exactly how the economy would grow over the coming quarters. The ECB also acknowledged that the stress tests carried out on the financial sector have lifted a lot of doubts and have played a key role in improving the money markets, while austerity measures and coordination in fiscal policy among member countries are helping to calm tension in the sovereign debt markets.
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The ECB stops its public debt purchase programme.
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Within this improved context, the ECB has practically discontinued its programme to buy up public debt in secondary markets, at the same time as the amount of loans requested by financial institutions has fallen significantly. As a result, surplus banking reserves in the system have shrunk and the one-day interbank interest rate (EONIA) has undergone a modest but revealing rise. The Euribor interbank interest rate has continued to evolve gently, easing in August given the unexpected slowdown in the global economy, as well as more confidence among institutions after the publication of the stress test results on 23 July.
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Public debt markets: sharp fall in yields
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In April, when the sovereign debt crisis erupted in the euro area, investors sold off the bonds of those countries whose fiscal consolidation was in doubt, such as Greece, Spain, Portugal and Ireland and took refuge in the debt of countries with high credibility, such as France and especially Germany. This movement led to a huge rise in the spreads between interest rates for these two groups of countries.
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The measures implemented limit the effects of the sovereign debt crisis in the euro area.
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Given this emergency, the European Union and member governments adopted an extensive battery of measures to put a stop to systemic risk (including the creation of a European stabilization mechanism provided with 750 billion euros). As the substance of these economic policy decisions took hold among investors, the crisis was contained. Consequently, since the middle of July, this change in sentiment has led to centre-periphery differentials closing the gap slightly.
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Although the process of reducing interest rate differentials is not uniform.
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It should be noted, however, that spreads have not shrunk equally throughout the different countries in question, nor have pre-crisis levels been achieved. And neither has this decreasing trend been uniform. For example, the announcement of high losses in one of the large Irish banks once again led to tension in the Irish bond differential, so that, by mid-August, the Treasury of Ireland had to offer a yield of 5.38% to sell its issue of 10-year bonds. In the case of Greece, the good news concerning the drop in its fiscal deficit was accompanied by figures showing sharp economic shrinkage, leading to doubts regarding whether the country can withstand this situation for very long. Lastly, confusion concerning the definitive adjustment in Spain's public investment harmed the spread for Spanish debt compared with German bonds.
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Although the sovereign risk factor in the euro area cannot be deemed to be neutralized once and for all, its place in the limelight has been taken over by concern about the prospect of lower growth in the United States and China. This concern is the fundamental element behind the additional fall in yields experienced in August and has since spread to the public debt of most countries. In the case of 10-year bonds from the United States, their rate is close to 2.50%. This level is near the record low reached at the end of 2008, namely 2.05%, precisely at the most critical time in the financial crisis caused by the bankruptcy of the North American bank Lehman Brothers. For its part, long-term German debt has already hit record lows, below 2.15% for 10-year bonds.
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It seems unlikely that this downward trend in yields will continue over the coming months, for two reasons. The first is that the worst in terms of economic shrinkage in the most important economies is now several quarters in the past and the recent slowdown will be short-lived. Secondly, because the yield levels reached by short and medium-term bonds are already very close to the nominal minimum of 0%. In the medium term, and as economic data confirm that the slight slowdown in growth is not putting a stop to the recovery, there should be a small upward trend in yields, returning to the levels seen in April this year.
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Worsening growth prospects affect the dollar
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Doubts concerning growth in the United States drive the dollar's depreciation.
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The currency market has not been immune to the prospects of synchronized slowdown in growth in the United States and China. The most notable consequence has been the fall of the dollar against other leading currencies. For example, although one euro was worth around 1.24 dollars in mid-June, it had quickly reached an exchange rate of 1.33 dollars by the beginning of August. This situation has now partially corrected itself and the euro is now worth around 1.27 dollars. The dollar's depreciation has also been sharp against the Japanese yen, falling 6% since the beginning of June.
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The Chinese authorities create a pilot programme to internationalize the yuan.
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Of note in Asia are the progressive movements made by the Chinese authorities to normalize their exchange policy. With the announcement by the People's Bank of China that it would start to operate with other central banks in the cross-border settlement of yuan in Hong Kong and Macao, another step has been taken in freeing up control over the yuan. China will also allow foreign banks to operate in its domestic interbank bond market in order to internationalize its currency. In this way it hopes to extend use of the yuan in the international financial system.
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Corporate debt looks solid
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Trends remain good in the private bond market...
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Corporate bond markets have continued to perform solidly over the summer months. This can be seen in the aggregate indices, posting very significant rises. The main factor has been the success of the European stress tests, with some Spanish banks performing exceptionally well. Another positive element has been the relaxation and delay in applying the Basel III banking regulations. Within this environment, the banking sector has performed particularly well compared with the rest of the economic sectors.
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...although doubts concerning growth in the United States slow up the pace of recovery.
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In fact, since the start of the economic recovery the private bond market has seen very positive trends, both in prices and volumes, compared with the rest of financial assets, satisfactorily overcoming the different storms that have appeared throughout this period.
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For example, during the month of August, the positive trend in corporate bond markets has slowed up but not stopped, due to the already mentioned publication of various indicators that raise doubts regarding the future pace of growth in the United States and China.
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The key element underlining the recovery in this market is firms' now healthy financial situation.
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In any case, the private bond market has one factor that is key in the current situation: the results of large international firms, which in addition to being highly positive are also being systematically better than expected by analysts. This situation, which has been occurring since the first quarter of 2009, has led to a rapid accumulation of financial resources which, combined with sluggish investment, results in a strong cash position. Consequently, most of these firms are not under pressure from new financing needs and can even take advantage of the propitious moment in the private bond market to comfortably refinance their debt at very low interest rates.
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This good performance has spread to the bonds of high risk companies.
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The strength of the private bond market has also spread to the emerging economies because these offer higher potential growth than developed economies and their companies also issue bonds with more attractive yields. This has been confirmed by the sharp rise in the volume of high risk bonds issued and with the strong growth in flows towards emerging countries, in both cases breaking records.
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Private bond prospects continue to look good.
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One notable fact at present, given that markets are highly sensitive to news concerning the credit risk of corporate debt, is that the positive trend is remaining firm in the debt rating for high risk (or high yield) firms, compared with the stability in debt rating of high rating firms (or investment grade) firms.
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Within this context, investors are still interested in the private bond market and continue to invest apace in this kind of asset, although corporate bond interest rates have fallen to record lows. Given this situation, and attracted by the higher returns offered by high risk bonds, investors have increased their exposure to this segment. The outlook for the corporate bond market is still positive as long as there's no significant change in expectations for economic growth, insofar as the corporate and flow parameters that underlie this trend remain in place.
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Stock markets turn their gaze towards the economic cycle
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Stock market indices continue to move laterally.
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During the summer, the main international stock market indices did not lose the weak, irregular pulse that has characterized them throughout the year. Although July's record lows are now behind them, they haven't managed to consolidate any upward trend. As has already been noted, improvements due to the handling of the sovereign debt crisis in the euro area have been replaced by concerns regarding growth in the United States and China and the impact this might have on company results in the coming quarters.
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The outcome of the stress tests on the euro area's financial system is key to equity.
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As often happens during the summer, activity has been sluggish. Flow indicators continue to show that retail investors are still reluctant to invest in equity, preferring less risky assets such as corporate bonds.
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There are three decisive factors that have particularly helped to reduce the high volatility shown by stock markets at the start of July. Firstly, the positive outcome of the stress tests carried out on the European banking sector. The conclusions of this analysis, carried out on 91 financial institutions, helped to dispel doubts concerning the stamina of the European banking system, showing banks to have a high degree of transparency and solvency in a potentially adverse scenario.
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Another important element is the good corporate earnings season for the second quarter.
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Secondly, the positive outcome of the corporate earnings season for the second quarter, both in the United States and in the euro area. For the sixth consecutive quarter, the corporate profits of the S&P 500 companies were higher than expected by the consensus of analysts, with a 36% rise in profit per share compared with the same period a year ago. Similarly, in the euro area, and although lagging behind slightly, firms' margins have accumulated widespread gains since last autumn, particularly in the industrial sector.
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Now investors are closely following global growth prospects and their impact on firms.
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Lastly, the handling of the sovereign debt crisis in the euro area has led to lower risk aversion by investors regarding equity, compared with the turbulent months from April to June.
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This renewed calm in the stock markets was ruffled in the middle weeks of August by the already mentioned publication of unfavourable economic data for the United States and China. This has led to the resurgence of fears of a relapse in the global economy, and European stock markets have not remained untouched. This situation might continue for some time to come but the probability of a double-dip recession seems faint at present so that, in the medium-term, aspects such as the continuing recovery in corporate earnings, the improvement in the financial sector's situation and the fall in sovereign debt yields for periphery countries of the euro area should help the stock markets to rise.
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